ESG Considerations for Securitized Fixed
Neil Hohmann, PhD Managing Director Income Notes Head of Structured Products BBH Investment Management [email protected] +1.212.493.8017 Executive Summary
Securitized assets make up over a quarter of the U.S. corporations since 2010, we find median price declines fixed income markets,1 yet assessments of environmental, for equity of those companies of -16%, and -3% median social, and governance (ESG) risks related to this sizable declines for their corporate bonds.3 Yet, the median price segment of the bond market are notably lacking. decline for securitized notes during these periods is 0% – securitized notes are as likely to climb in price as they are The purpose of this study is to bring securitized notes to fall in price, through these incidents. This should not be squarely into the realm of responsible investing through the surprising – securitizations are designed to insulate inves- development of a specialized ESG evaluation framework tors from corporate distress. They have a senior security for securitizations. To date, securitization has been notably interest in collateral, ring-fenced legal structures and absent from responsible investing discussions, probably further structural protections – all of which limit their owing to the variety of securitization types, their structural linkage to the originating company. However, we find that complexities and limited knowledge of the sector. Manag- a few securitization asset types, including whole business ers seem to either exclude securitizations from ESG securitizations and RMBS, can still bear substantial ESG assessment or lump them into their corporate exposures. risk. A specialized framework for securitizations is needed. A common presumption, given the lack of method, is that securitizations are at best neutral, and possibly a detractor We have developed an ESG evaluation framework, custom- from an ESG risk viewpoint. ized to these features of securitizations, in order to properly analyze their environmental, social, and governance We question that presumption. Analyzing the periods exposure. The framework has three pillars: surrounding the more severe ESG incidents2 at U.S.
Pillars of the BBH ESG Evaluation Framework for Securitizations
PILLAR 1 PILLAR 2 PILLAR 3 Identify and assess Analyze the underlying loan or Analyze the governance the nature and strength lease pool of the securitization integrity of the of all corporate linkages from an ESG perspective securitization trust
Identify and assess linkages Any sizable concentration in the Analyze the securitization trust to a securitization (whether pool to a single loan borrower with (including the strength of its originator, servicer, or elevated ESG exposure may add standalone legal structure, guarantor). For each corporate further risk to a security. Such the clarity of cashflow rules, entity with a significant loan-related exposure may be the identity and role of the linkage to the trust, a separate mitigated, however, by a large independent trustee) from corporate ESG evaluation issuer equity position beneath the an ESG perspective. should be performed. securitized note or by structural protections in the transaction that accelerate repayment to noteholders if performance weakens.
Once the risk exposure from each of these three pillars has been assessed, they can be aggregated into a single ESG risk measure for the entire trust.
We provide an example of the application of this framework risk exposures for securitizations are generally low relative to a small-ticket asset-backed securitization (ABS) transac- to the range among unsecured corporate bonds. There are a tion. Using this framework, we then provide an overview of number of meaningful exceptions to this, however, strongly ESG factors and categorize their intensity across more than underscoring the need to apply a specialized ESG framework 30 sectors/subsectors of the securitization market. We find to securitized fixed income.4 that the environmental, social, and particularly governance
1 SIFMA, Outstanding Bond Market Debt 12/31/18. 2 Severe ESG events are tracked, analyzed and classified by ESG ratings and research provider Sustainalytics. 3 The better performance of corporate bonds versus equities during ESG incidents illustrates the mitigating effect of their more senior position. 4 Like securitizations, certain secured corporate bonds and loans also rely on dedicated security packages and structural protections to insulate from corporate ESG event risk.
1 1 Introduction
Securitized notes and bonds are issued by standalone legal features of a securitization – its independent legal status, entities whose sole purpose is to purchase loan and lease bankruptcy remoteness, reliance on dedicated collateral, collateral pools, issue debt, and distribute interest and and structural mitigants. In our experience, it is important to principal cashflows to debtholders. They have limited (and recognize corporate linkages as part of any ESG assessment. in many cases no) linkage to operating companies. But such linkages should only be part of a broader ESG analysis that considers their relevance, the securitization’s The securitization market is diverse, spanning credit, agen- legal separateness and governance integrity, and the quality cy-backed, and government-guaranteed collateral types. and diversity of the underlying collateral pool. These include agency mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), asset- An analyst of an auto loan ABS, for example, might consider backed securities (ABS), and collateralized loan obligations the corporate health of the auto lender as just one factor, and (CLOs). There are important commonalities. Securitized perhaps even a minor one, in the assessment of a credit. An bonds typically have an independent legal structure. They ESG assessment of this ABS should strive to place the risks benefit from the security of an underlying pool of loan and from governance failures at the auto lender in proper context lease assets. There are stringent, transparent rules for the with, say, any adverse social impacts from the auto loans distribution of collateral cashflows to noteholders, which are themselves, as well as the integrity of the note trust – its administered by an independent trustee. Finally, there are independence, stability, governance structure, and adminis- important structural protections for noteholders that can tration by a trustee. In addition, structural protections (like include equity and subordination beneath notes, sequential excess interest, subordination, and cashflow redirection in payment rules, and performance-related triggers to protect event of distress) can help ABS noteholders mitigate this noteholders in the event of collateral deterioration. combination of risks from corporate ties, the loan pool itself and the trust structure itself. These mitigants can help a Securitizations and Corporate Linkage securitization weather a severe ESG event that would devastate the originating company. For corporate equities and bonds issued by large public companies, ESG assessment is supported by large existing Appropriate ESG Framework databases of company benchmarks and an evolving body of ESG evaluation criteria. There is little practical guidance, Developing an appropriate ESG framework for securitizations however, on how to evaluate MBS, CMBS, ABS, and CLOs is no academic exercise. We demonstrate that the returns from an ESG perspective.5 One simple approach equates the for securitized notes during a severe ESG event are quite environmental, social and governance risk in a securitization different than for equity or corporate bonds. Simply tagging with the corporate ESG rating of the originating or servicing a securitization with the corporate ESG rating of its originator company. This approach erroneously treats a securitized note is not only misguided but rejected by empirical evidence. solely as a corporate obligation. It ignores all the distinctive
5 See, for example, CFA Institute, “Guidance and Case Studies for ESG Integration: Equities and Fixed Income.” Chapter “Fixed Income Case Studies: Structured Credit,” by Singer, McDonogh, Guo, and Reback of Angel Oak Capital Advisors. Their paper recognizes the practical difficulty of attaching a corporate ESG rating to each securitization trust without performing deeper due diligence into the securitization’s attributes.
2 2 Owning structured fixed income notes insulates investors from ESG event risk
Independent structures, dedicated collateral, and structural The methodology of the analysis is described in the Appendix. mitigants tend to insulate securitized notes from the fallout of Daily return data was analyzed for companies that meet all of severe corporate ESG events at their originator or servicer. the following criteria: This is very clear when one compares the daily returns of a company’s securitized notes, through the course of a severe • Experienced an ESG incident of severity 5 or higher on ESG incident, to their corporate bond and equity returns. Sustainalytics’ severity scale.
We examined the daily price returns of the equity, corporate • Had U.S. dollar public equity, corporate bonds, and securiti- bonds, and securitized bonds of the companies that experi- zations outstanding at the time of the incident. enced the most severe ESG incidents from 2010 to the • Had reliable daily price data available for all security types. present (the available length of the Controversies historical data set). These incidents are assessed and classified by Exhibit 1 below describes the resulting data sample of nine ESG ratings and research provider Sustainalytics. companies and their associated ESG incidents that met all of these criteria.
EXHIBIT 1: Recent ESG Incidents
Incident Ultimate Incident Company Date Severity Incident Description
JP Morgan 2012 8 Discloses trading loss of $6.2 billion stemming from a hedging strategy.
American Express 2014 6 US DOJ finds violations of the Sherman Antitrust Act for more than a decade.
Credit Suisse 2014 6 EU investigation into Swiss franc rate-fixing.
General Motors Co 2014 10 Recalls millions of vehicles for power steering failures.
Hertz Global Holdings 2014 5 Class action lawsuits accusing Hertz of misleading shareholders on company's performance.
Nationstar 2014 5 New York regulator focuses on rapid growth of non-bank servicers
Sallie Mae 2014 7 Regulatory investigations of loan servicing practices.
Ford Motor Co 2016 7 Recalls millions of vehicles for air bag inflator failures.
Wells Fargo 2016 10 Regulators find customers pushed into fee-generating accounts they never requested.
Sources: Sustainalytics and BBH Analysis
Exhibit 2 on the next page shows how the incident analysis with equity prices dropping a cumulative 9% and corporate was conducted for each company, using General Motors as an bonds selling off 2%. By contrast, the prices of GM’s example. In early 2014, the U.S. Justice Department began a securitized debt, both AAA-rated senior and lower-rated criminal investigation into evidence that GM had ignored faulty junior tranches, showed little impact. While nominally ignition switches for a decade, resulting in several deaths. sponsored and serviced by GM, auto loan ABS notes are viewed differently by investors than the debt of the GM As Exhibit 2 demonstrates, General Motors (GM) equity corporation. The ABS notes are independently collateralized (blue line) fell dramatically as the investigation was nearing, by auto loans under a separate trust structure. The headline
3 3 litigation concerns that moved GM equity and corporate debt That securitizations can insulate investors from severe prices had little impact on ABS. This is a typical pattern we ESG risk at the corporate level is illustrated in the aggregate find in our analysis – securitizations can insulate investors results of the incident analysis. For each of the 44 securities from major regulatory, governance, social, or environmental analyzed across the 9 companies that experienced a high crises that their originating company may experience severity ESG incident as determined by Sustainalytics, we (Appendix 2 shows similar incident analysis for the other calculate its maximum price drawdown over the analysis companies in the data sample). period, i.e. the period of peak price impact from the incident.
EXHIBIT 2: Cumulative Price Return Accompanying ESG Incident – General Motors
2
0
-2
12 201 : The .S. Justice Department started a - criminal investigation into General Motors vehicle recall, focussing on faulty ignition switches -
-8
-10
GM Equity GM Corp BBB GM ABS AAA GM ABS AA GM ABS A
Sources: Bloomberg and BBH Analysis
Exhibit 3 to the right shows the distribution of maximum EXHIBIT 3: Securitizations Show Least Return price drawdowns across the 44 securities by security type Drawdowns in Severe ESG Incidents in a simple box-whisker plot. The first quartile, median, and third quartile drawdown percentages are clearly tiered 0 across security types, with large equity impacts, substantial corporate bond impacts, and negligible impact to securitiza- - tions. The median price drawdown for equities is -15.8%, for corporate bonds it is -2.6%, and for securitizations it is -10 0%. The limited ESG event impact on securitizations is also apparent in the narrow range of drawdowns, as the 75th -1 percentile worst securitization drawdown is well below the 25th worst percentile corporate drawdown. Finally, of the -20 securitizations in the analysis, 14 out of 24, or more than half, showed no drawdown, i.e. prices were stable or -2 increased over the incident period. - 0
- Maximum Return Drawdown Accompanying ESG Incident
Corporate Equity Corporate Bond Securitized Bond
Sources: Sustainalytics and BBH Analysis
4 4 The results of this analysis show that the independent At the least, securitized notes should not be painted with structure and dedicated collateral pools of securitizations can the same broad ESG brush as corporate bonds and equities. insulate investors from severe ESG incidents at the originating Optimally, securitized notes should be evaluated through a company. This is not to say that securitizations don’t move in specialized framework, which recognizes the strength of price or aren’t sometimes closely linked to their corporate corporate linkages, their independent governance structure, originator, but the observed tendency is that securitizations and the quality of their collateral pool. We present such a avoid price reactions stemming from corporate ESG failures. framework in the following section.
A framework for ESG assessment of securitized notes
Based on many decades of experience in assessing securi- exposures associated with a company’s production, opera- tized notes and our long-standing presence in these markets, tions, and distribution. Social exposures can be identified BBH developed an ESG assessment framework that measures both within the company (e.g. human capital gaps, occupa- and weights the relevant ESG exposures to securitization tional safety issues, human rights violations in the supply noteholders. Corporate linkages in the securitization are chain) and outside the company (e.g. health impacts from identified and assessed, but they are evaluated alongside product usage, negative externalities, political distortions). equally important factors that raise or mitigate exposures – Exposure to governance shortcomings can be identified legal separation, strength of collateral security, independent and assessed, including the volatility and scope of business administration, and structural enhancements. operations, the breadth of experience and diversity within management, the integrity of management and its commit- Exhibit 4 contrasts ESG assessment for a corporate security ment to sound underwriting, the sufficiency of internal versus a securitized bond. On the left side, ESG risk factors policies, and the degree of transparency, both internal and enter in a conventional way in the corporate evaluation. external to the company. Direct assessment may be conducted of the environmental
EXHIBIT 4: BBH ESG Risk Assessment – Corporate Bonds vs. ABS
Corporate Bond Asset-Backed Securitization
PILLAR 1 PILLAR 2 PILLAR 3 Company Trustee
Bankruptcy Remote Trust Debt Originator Asset-backed Debt Servicer Loan Equity Guarantor Collateral Equity and Excess Interest Event Exposure E S G E S G S G
Corporate ESG Exposure Securitization ESG Exposure
Direct equity and bond exposure to: E – resource usage, carbon production, Indirect ESG exposure Potential ESG Governance other emissions through limited exposures affecting exposure due to any reliance on originating, repayment of legal or structural S – human capital shortcomings, human rights servicing, or guarantor underlying collateral weaknesses in violations, occupational safety issues companies – mitigated by loan trustee-administered G – product governance failures, ethics lapses, pool granularity and bankruptcy-remote data breaches geographical dispersion legal entity
The size of E, S, and G symbols represents relative ESG risk exposure from that category. For illustrative purposes only
5 5 Alongside the identification of such ESG risk exposures, the This step involves the same data and analysis required to degree to which a company successfully manages or mitigates evaluate each company’s corporate debt. these exposures through good management, policies, and communications is also assessed. Assessing ESG exposures Once the set of companies with meaningful linkages to the and their management requires access to high quality data for trust is identified and a separate ESG assessment of each the company: management communications, company company is developed, the strength of linkages of each policies, impact assessments, financials, media coverage, etc. company to the securitization is determined. Ongoing This ESG-related data varies in thoroughness and quality from relationships between the company and the trust and the company to company. It may be obtained directly through the impact of certain structural features must be understood. company, through third-party ESG assessment firms, or Considerations on the strength of linkages include: gathered directly by the analyst. • What are the trust’s servicing needs? Certain loans and By contrast, an ESG assessment for a securitized bond must leases have low default rates and are quite simple for many cover more ground. For securitizations, the broader assess- industry participants to service. Others may have high ment can be grouped into three categories: touch servicing or collections requirements or need to be re-leased over the life of a debt transaction (aircraft, for 1 Indirect corporate ESG exposures related to the originator, servicer, and/or guarantor of the example). A greater servicing involvement over time in the collateral pool. performance of the loans means a stronger linkage to the servicing company. The securitization trust is an independent legal entity that owns the loan or lease collateral, the cashflows of which are • Is the collateral pool closed, i.e. static over the life of the appropriately allocated to trust noteholders by an indepen- security? If not, and the originator is expected to contribute dent trustee. A trust is structured so that its collateral assets new loans over the deal’s life, then the linkage of the trust may not be attached in any restructuring of the operating to the originating company is likely to be more meaningful. companies that may have originated or service the collateral. • What is the strength of the trust’s security interest in the This independence substantially limits the impact on the trust collateral? For most securitized asset types, the securitization of a major ESG event at these operating trust’s security interest in the collateral is well-tested and companies relative to the impact on their corporate debt. understood, including mortgages, title or Uniform Commer- Securitization investors can typically expect to avoid impair- cial Code (UCC) filings. For certain asset types (e.g. whole ment to their notes even following extreme events at the business securitizations), the security interest can be more operating companies of the originator or servicer that result complex because the linkage to the health of the issuing in their bankruptcy and in corporate bond losses. This is company is high. Legal jurisdiction outside the U.S. can illustrated in the prior Exhibit 4. The ESG risk exposure also detract from the security interest. indicators beneath the Originator/Servicer/Guarantor expo- sure channel of a securitization are much smaller than the • Is there implicit support from an originator or servicer? corresponding direct corporate exposure indicators on the Securitization investors are not accustomed to relying on left for a corporate bond. ESG exposure from any corporate sponsors to make good on any losses experienced in the linkages is typically reduced by the securitization structure. trust, but certain asset types nonetheless enjoy ongoing support from sponsors (e.g. timeshare ABS). Here, the Nevertheless, distress at the originator, servicer or guarantor implied linkage to the sponsoring company is stronger. of collateral loans can present some risk to a securitization, so an ESG assessment should seek to identify any meaningful Evaluating the strength of such linkages between the trust corporate linkages. Such linkages could include the capability and operating companies requires a different type of analysis of the company to make collections on securitization loans or and data than a conventional corporate ESG assessment. to originate new loans into a revolving securitization trust. Trust pooling and servicing agreements, the nature and Unlike ESG assessment of a corporate bond, there may be scope of servicing operations and ongoing portfolio manage- linkages to more than one company in a single securitization. ment responsibilities, true sale and security documentation, One company may originate the loans, while another com- and potential portfolio substitution activity should all be pany services them. A portion of the loan pool could be understood and reviewed. Substantial information must be guaranteed by a third company. (See Exhibit 5 on the next gathered on the trust beyond what is typically involved for page.) While the strength of these corporate ESG linkages a company assessment. This information is typically made are typically weaker for a securitization, an analyst should still available to securitization investors at issue and through develop a corporate ESG analysis on any operating companies regular transaction reporting. to which the trust may have meaningful exposure.
6 6 EXHIBIT 5: ESG Risk of Originator and Servicer
PILLAR 1 PILLAR 2 PILLAR 3 Trustee
Bankruptcy Remote Trust Guarantor
Asset-backed Debt Originator Loan Collateral Equity and Servicer Excess Interest
E S G S G Exposure Indirect exposure to ESG weakness at companies Indirect ESG exposure at the individual Exposure to any governance issues that service, originate, or guarantee loan collateral companies or consumers that are in the trust Often just a single servicing company for a trust, borrowers for the loan collateral but sometimes one company plays all three roles
Management • Closed, static pool of seasoned loans • Loan pool is highly granular across • Simple rules-based governance & Mitigants • Minimal servicing need hundreds or thousands of loan obligors structure documented in bond indenture and service contracts • Bankruptcy remoteness and true sale treatment • Geographical and industry diversity • Obligor concentration limits • Administration by independent • Servicing contracts delineate duties of company, trustee including conditions for replacement • Equity, subordination, and excess interest insulate debt from loan losses • Sequential cashflow rules protect • Reps and warranties on loan collateral debt, both pre- and post- default • Backup servicer • Transparency and carveouts for environmental exposures in loans • Bond structural protections accelerate repayment under duress
The size of the E, S, and G symbols represents relative ESG risk exposure from that category. For illustrative purposes only
means a greater degree of linkage to the ESG risk of the 2 Indirect ESG exposure through individual company borrowing company. Most securitizations are highly granular or consumer borrowers in the collateral pool and have no particular obligor or geographical concentrations. Apart from originator and servicing linkages, securitizations However, there are several securitization types where may also be exposed to ESG risk through their underlying borrower concentrations are high. One example is whole loan or lease collateral pool. This exposure could be either business securitizations where an ABS is secured by asset- through a large concentration to a single corporate obligor in level cashflows associated with a single company. In this the loan or lease collateral pool or from a social or environ- case, corporate exposure is not meaningfully different than mental exposure introduced to a large set of borrowers for the unsecured debt of the company. through particular loan or lease features. As an example of the second, loans in the collateral pool As an example of the first, if a collateral loan to a single may collectively impose specific social or environmental company is large enough, say 15% of the overall collateral costs on a group of borrowers. A securitization of pay-day pool, a severe ESG event at that borrowing company (like a loans with punitive interest rates or a portfolio of royalties on product recall or a work stoppage) could affect the perfor- oil wells are two examples. Similarly, the carbon emissions mance of the securitization. A higher obligor concentration associated with a large fleet of trucks add to the aggregate
7 7 environmental exposure of a fleet lease ABS. Conversely, By contrast, the governance structures of securitizations a securitization of reasonable rate loans to lower-income are much simpler. They are transparent, and typically borrowers or a portfolio of energy efficiency loans brings administered by an experienced trustee agent. The purpose social and environmental benefits. Generally though, and activities of a securitization are far more limited than an securitizations are secured by decades-tested essential operating company. They issue bonds, purchase collateral, consumer and commercial lending products and so typically and then administer interest and principal payments to impose no particular ESG burdens on borrowers. noteholders under specified priority rules until noteholders are repaid and the trust is dissolved. Hence, governance Assessment of such indirect ESG exposures embodied in problems in securitizations are unusual. As Exhibit 5 the loan collateral pool itself is performed separately. It is in this section shows, a securitization’s direct exposure influenced and mitigated by several trust-specific factors: to governance risk (shown on the right) is typically much smaller than the governance risk in a large corporation (on • Is the loan pool granular across hundreds of loans? the left). If not, and there are larger concentrations, linkage of the trust to the obligor is likely to be more meaningful. This said, securitization structures are subject to gover- nance weaknesses that may be more likely to emerge when • Are there obligor concentration limits to prevent underlying loan performance is poor. Also, ambiguity in deal large obligor concentrations from emerging in documents, poorly designed cashflow waterfalls or amorti- the portfolio? zation structures, insufficient oversight of servicing, and • Is there industry and geographical diversity within the poor reporting can all create governance risks for securitiza- collateral pool? tion investors.
• Even where linkage to a single obligor may be meaning- To assess such risks, it is useful to consider: ful, structural protections including equity, subordina- • Is a simple rules-based governance structure properly tion and excess interest can insulate investors from documented in bond indenture and service contracts? corporate ESG exposure of a single obligor. • Is there appropriate oversight and administration by an • Environmental issues in underlying loans and collateral independent trustee and auditor? are often identified by consultants and environmental exposure is structurally carved out. • Do sequential cashflow rules adequately protect lend- ers, both under normal conditions and during periods • Bond structural protections can accelerate repayment of stressed performance? under duress, limiting ESG exposure. • Does the trustee provide accurate, timely, and detailed Certain data sources must be consulted to determine ESG reporting of collateral performance, debt repayment, exposure through the collateral pool and the degree to which and structural functioning? it is mitigated by loan attributes and bond structural features. The analyst should obtain loan-level data and pool-level Evaluating the governance risk within a securitization also stratifications, portfolio concentration rules, the equity and involves review of additional data, including bond prospec- subordination profile, rules for cashflow waterfall under tuses and indentures, trustee statements and references, various performance scenarios, and environmental impact documentation of cashflow priorities and empirical perfor- assessments and carveouts. mance for other securitizations in the shelf or industry, and examination of regular pool, debt, tax, and financial reporting. 3 Exposure to governance issues in the securitization trust
Corporate governance structures, particularly at large compa- nies, can be multi-layered and complex. Ultimately they are only as good as their implementation and adherence by management and employees. Serious lapses can result in deleterious outcomes.
8 8 An ABS example in the BBH ESG securitization framework
The following chart is an example of ESG analysis for a former CEO five years ago and the current management securitization. Amur Equipment Finance Receivables, Series team has been in place for several years. Board composition 2019-1, is a securitization of 2,755 equipment leases origi- is composed primarily of management and Blackstone, with nated and serviced by Amur Equipment Finance (Amur EF). limited independent directors. Operational execution has been strong, but we don’t have the transparency in opera- Some facts: tions and policies that we would for a public company. We have over a decade of underwriting statistics and perfor- • Amur EF is a commercial equipment lessor founded in mance data that indicates that Amur has maintained consis- 1996 and headquartered in Grand Isle, Nebraska. tency in its lease underwriting. • Amur EF finances 90 categories of equipment (e.g. trucks, These respective environmental, social, and governance trailers, food service equipment, construction vehicles, and ESG risk levels for the company Amur EF are denoted by medical equipment) for small and medium-sized compa- the relative size of the E, S, and G symbols on the far left nies across the country through a network of over 2,000 of Exhibit 6. equipment vendors. Next, we assess the strength of corporate linkage • Series 2019-1, issued in July 2019, is Amur EF’s seventh between the company Amur EF and the Series 2019-1 lease securitization. trust. The ESG risk at Amur EF is only relevant to the • The lease contracts, valued at $280 million, were sold by securitization to the degree that there is a meaningful Amur EF to a Delaware trust established for Series 2019-1, corporate linkage to the trust. which is administered by trustee Wells Fargo. We assess the corporate linkage of Amur EF as an originator • The Series 2019-1 trust issued ABS notes in July 2019 to be negligible. The 2019-1 trust is a static pool, which totaling $255 million that are secured by the lease contracts. means that all lease contracts in the trust are sold into the trust at its inception and have already been originated by An ESG analysis of the Series 2019-1 notes begins with Amur. The quality and capacity of Amur for future lease an assessment of any corporate linkages to the trust. originations is not particularly relevant to the trust. Amur EF is both the originator and servicer of the lease. There is no guarantor of the leases, and no other meaningful We assess the servicing linkage of the trust to Amur EF to be corporate exposure for the trust. A corporate ESG analysis is low. Amur is the designated servicer for the trust collateral so therefore performed just on Amur EF, looking at the company there is some linkage. However, the exposure of the trust to just as we would an assessment of its debt or equity. severe ESG events at Amur EF is mitigated by several factors. Based on review of legal opinions of true sale, non-consolida- Performing the analysis (see the far left of Exhibit 6), we tion, and security interest, we find that the Series 2019-1 trust determined that the environmental exposure at the company adequately protects against risk that the assets of the trust is very low. Amur EF is a financial services company that could be attached in a bankruptcy of Amur EF. The servicing leases equipment across a diverse range of the U.S., with requirements for equipment lease contracts are not particularly some concentration in trucking. complex. There are well-specified conditions for replacement of Amur EF as servicer in the event of underperformance and Social exposures of the company are moderate. For example, Wells Fargo is an experienced designated back-up servicer for Amur’s lease contracts are an essential source of financing the trust in this event. Since we deem the servicing linkage of for its lessees at competitive rates. There are no supply-chain Amur EF to the trust to be low, Amur EF’s corporate ESG issues, but as is common at privately-held companies, there exposure is mitigated within the Series 2019-1 trust. This is is limited information on human resources policy for the evident in the much smaller size of the ESG exposure symbols company’s 135 employees, who are spread over five offices. beneath the corporate linkages in Exhibit 6. Our analysts must engage senior management directly to gather such information. The next pillar of assessment of Series 2019-1 is ESG risk that arises through the lease pool itself. Note from the We assess governance risk exposure of the company to be absence of symbols below the lease pool in Exhibit 6 that medium. The company is co-owned by its Chairman and we have assigned no ESG risk to the lease pool. The pool of CEO Mostafiz Shah Mohammed and a Blackstone private 2,755 contracts is highly granular with no single borrower equity fund. The company completed a separation with its
9 9 EXHIBIT 6: Amur Equipment Finance Receivables, Series 2019-1
PILLAR 1 PILLAR 2 PILLAR 3 Trustee: Wells Fargo
Amur Equipment Finance Receivables, Series 2019-1 Servicer Linkage: AAA-rated ABS Amur Equipment Finance Low 2,755 Equipment Lease Contracts E S G Originator Linkage: $280 Million Subordinate ABS Negligible Equity & Excess Spread
E S G G E S G
• Static pool of seasoned leases • Highly granular across 2,755 equipment • Rules-based governance structure • Moderate servicing requirements leases to SMEs well-documented in bond indenture and service contracts • Bankruptcy remote Delaware trust • Broad geographic and industry diversity, with some trucking concentration • Administration by independent trustee • Legal opinions to true sale, non-consolidation, Wells Fargo and security interest • Obligor concentration limits, 0.9% to largest • Straight sequential cashflow rules • Well-specified servicer termination conditions • 8% equity, 19%, subordination and excess interest protect debt holders, with separate • Appropriate reps and warranties pre- and post- default waterfalls • Elevated delinquency and loss triggers early • Backup servicer arrangement in place amortization of debt
The size of the E, S, and G symbols represents relative ESG risk exposure from that category. For illustrative purposes only.
concentration over 1%. Lease contracts are diversified higher governance risk at the Amur EF operating company. geographically across the U.S. with diversity across indus- We have developed assessments of the ESG risks for tries and a moderate concentration to trucking. These Series 2019-1 that derive from each pillar: amount to minimal risks at the lease pool level, which is • corporate linkages to Amur EF, further mitigated by a substantial equity position of Amur EF beneath the notes and structural protections that accelerate • the lease pool itself, repayment of notes to investors in the event of elevated lease delinquencies or losses. Overall, we deem there to be • the trust governance structure. negligible ESG risks to the trust through the lease pool itself. In a final step we aggregate these three sources of ESG risk Finally, examining the rightmost pillar in Exhibit 6, we into a single ESG risk measure for the Series 2019-1 trust deem there to be low governance risk deriving from the (see the bracket in Exhibit 6). Overall, we deem the environ- Series 2019-1 trust structure. As the seventh securitization mental risk to be negligible, the social risk to be very low, and in the shelf, we have long historical experience with this the governance risk to be low. This contrasts with the higher structure. We verified that the 2019-1 trust has well-specified ESG risk assessed for the company Amur EF, which does not rules for the distribution of lease cashflows to note investors, benefit from the simpler independent governance structure that these rules and Amur’s responsibilities are appropriately of Series 2019-1. We commonly find through this type established in the note indenture and service contracts, and of bottom-up analysis that securitizations have lower that the trust is operated and administered appropriately by overall ESG risk exposures than the company-level risk trustee Wells Fargo. (We do recognize an additional risk factor of their originators. however in Wells Fargo’s own checkered profile.) The gover- nance risk in this simpler trust structure contrasts with the
10 10 A survey of ESG risk across securitization sectors
With an appropriate ESG assessment framework for securi- For MBS sectors related to the Financial Crisis, including tized notes in hand, one can apply this framework broadly to legacy pre-crisis and modified re-performing RMBS, this sectors and issuers to obtain a map of exposure levels across should come as no surprise as these loans are performing the structured fixed income universe. On the following page, more poorly than underwritten, involve heavy servicing using the framework described in the prior section, our burdens, and are challenging borrowers’ capacity to afford analyst team has constructed an ESG Risk Assessment them. However, Agency MBS, typically regarded as U.S. Heat Map (Exhibit 7) showing the range of ESG exposure government risk, and Credit Risk Transfer (CRT) are we find across more than 30 individual segments of the assessed to have moderate to high social and governance securitized markets. risk exposure. The reason for this is the very high corpo- rate linkage of both sectors to the U.S. housing agencies. Within each sector there are typically multiple issuers. Agency MBS loans are guaranteed by agencies like Fannie Where differences across the issuers in a sector are Mae and Freddie Mac. CRT represents deep subordinated meaningful, we show a range of ESG exposures in that credit exposure to these same mortgage pools. Both category to reflect this variability. For instance, on the map exhibit an unusually strong corporate linkage for a securi- the degree of social risks for different subprime auto ABS tized sector. Given the legislative uncertainty over the issuers ranges from very low (light green) to severe (red). future of the agencies and the role they may play in Each issuer has its own profile of corporate linkages of responsible lending in the U.S., a moderate level of social various strengths to companies with varied ESG exposures. and governance risk is assigned to agencies and therefore, Each issuer also has its own trust governance structure and with the tight corporate linkage, to the MBS itself. While distinct collateral pool attributes. In subprime auto lending in MBS risks may be elevated over other securitization particular, there is a diverse spectrum across issuers on the sectors, agency MBS risk exposures are still modest in affordability, rates, and transparency of their lending, a key the context of many corporate ESG exposures. contributor to the level of social risk in their loan product (at one end might be GM Financial, at the other a “buy 3) Certain consumer ABS sectors exhibit elevated social here-pay here” issuer). The range shown within each risk risk that relates to concerns over the social value of the category therefore represents the assessed difference in underlying lending product. FFELP student loan ABS, risk across issuers in that sector. marketplace consumer ABS and certain subprime auto ABS place questionable debt burdens on borrowers. Observations In addition to possible social detriment, these lending products may bring media and regulatory scrutiny which 1) One immediate conclusion from the map is that ESG risk elevate their risk profile. exposure levels across the securitization market are often low, particularly for environmental and governance risk. 4) Other securitization sectors that show more elevated As a point of reference, the degree of ESG risk exposure social and governance risk exposure include whole for unsecured corporate bonds, as assessed by third- business ABS, rental fleet ABS, FFELP student loan ABS, 6 party researchers, has a wide range. Securitizations timeshare ABS, and collateralized loan obligations (CLOs). often have a lower risk profile than unsecured corporate The elevated risk profile in these sectors is related to their bonds, reflecting advantages that their independence, higher than typical corporate linkage. Whole business simplified structures, and diversified collateral pools securitizations, in particular, are credit pass-throughs to provide. These types of structural risk mitigants, are not the underlying company and essentially share the underly- a feature unique to the securitization market. Secured ing company’s ESG exposure. Rental fleet and timeshare corporate bonds, with their own dedicated collateral ABS depend to a much greater degree on the corporate pool, also benefit from these structural ESG risk miti- health of their issuer than most securitizations. FFELP gants. Municipal revenue bonds frequently benefit from ABS student loans, like agency MBS loans, are guaran- structural protections that mitigate the extent of direct teed by the federal government and sensitive to program exposure to ESG risk of the municipality. changes. CLOs, diversified pools of high yield corporate loans, are still subject to some elevated risk from these 2) Another observation is that residential mortgage-backed corporate linkages on larger portfolio positions. securities (RMBS) appear to have elevated social and governance risk relative to other securitized sectors.
6 To get some context on the range of corporate ESG risk exposures, Sustainalytics distributes ESG risk across its company universe as 25% Low, 40% Medium, 25% High, and 10% Severe
11 11 EXHIBIT 7: BBH ESG Risk Assessment Heat Map Across Securitized Product Sectors
MBS ENVIRONMENTAL RISK SOCIAL RISK GOVERNANCE RISK Agency Concentrated exposure to U.S. housing agencies Highly dependent on shape of agency reform Exclusively non-performing loans to troubled Elevated servicing requirements for Re-performing borrowers modified loans Jumbo Prime Predominantly larger footprint homes Some gentrification and rental impact concerns Concentrated, junior exposure to housing CRT agencies Highly dependent on shape of agency reform Structural failures, unanticipated modifications, Pre-2008 Legacy Large component of non-performing loans servicer volatility CMBS Possible single site exposure but typically Single Borrower mitigated Conduit
ABS – Consumer Some structural shortcomings in face of FFELP Student Loan Concern over unaffordable student debt load defaults and extensions Low debt service burden but to near-prime Brick and Mortar borrowers High balance loans, online origination, Marketplace no bank license Concerns over single bank license model Subprime Auto Financing for internal combustion autos Essential use loan but to subprime borrowers
Credit Card Primarily prime borrowers
Prime Auto Financing for internal combustion autos
Solar Non-essential, sales concerns, ongoing Timeshare sponsor support ABS – Commercial Equipment Financing for emission-producing commercial Complex security and cashflows but structures Aircraft aircraft steadily improve Fuel efficient shipping mode, some accident Container potential Supply chain concerns Large-ticket Some vehicle financing Fuel efficient shipping mode, accident potential, Railcar oil and coal Small Ticket Some vehicle financing
Fleet Lease All vehicle financing
Rental Fleet All vehicle financing Lease concentration to a single rental company Lease concentration to a single rental company
ABS – Other Commercial Cell Tower Some sight pollution concerns
Data Center
Drug Royalty Some concern over high prescription pricing
Insurance-linked Attention focused on mortgage servicing Servicer Advance practices Small Business Loan
Tax Lien
Venture Debt
Whole Business High concentration to single underlying business High concentration to single underlying business High concentration to single underlying business
ABS – CLO Collateralized Mix of corporates with low to very high exposure Mix of corporates with low to very high Equity-friendly note terms can vary across Loan Obligations exposure transactions Unsecured Corporate Bonds
Very Low Low Moderate High Severe 12 Applying an appropriate framework for ESG evaluation resulting ESG risk mapping at an issuer and tranche level across sectors of the securitization market produces a novel should be an important tool in managing any responsible profile, and one that tends to have a lower ESG risk relative fixed income strategy. to many other credit sectors. Such a framework and its
Impact and responsible investing for securitization markets
There are interesting aspects of the securitization market for Finally, following the passage of the Dodd-Frank legislation investors beyond ESG integration. The securitization market, in 2010, issuers of securitizations are now required to provide particularly ABS and CMBS, offers an abundant range of investors greater transparency into their business models, impact investing opportunities, including solar ABS, energy their loan and lease portfolios, their representations and conservation ABS (PACE7), electrical vehicle lease ABS, and warranties, their contractual agreements with third parties ABS for consumer loans to minorities. The proportion of and their underwriting and servicing practices. A typical ABS “sin” industries within securitizations is de minimis, with prospectus, for example, is four times the size of an issuer’s negligible firearm, liquor, adult, or defense concentrations corporate bond prospectus. Participating in securitizations is in pools, and practically no casino exposure in CMBS. As a direct way for an investor to motivate additional company shown in the prior section, there are generally few high ESG disclosures that shine further light on its ESG risk profile. risk exposures in securitization markets. Issuers are for the most part financing essential services across a diverse range of U.S. industries and localities.
Conclusions
The thrust of this study has been the integration of securi- simplifying the securitized components of a portfolio during tized notes, a class representing more than one quarter of ESG assessment, this framework identifies the nature and U.S. fixed income, into an appropriate framework for ESG strength of a securitization’s corporate linkages, assesses the evaluation. This securitization framework takes its place quality and diversity of its underlying loan or lease pool and alongside our existing ESG frameworks for corporate bond analyzes the governance features of its independent legal and corporate equity evaluation. structure. It is applied to over 30 sectors of the securitized marketplace. In this context we observe that the securiti- There is currently an ESG void among fixed income zation market produces a novel ESG profile, and one managers’ structured product allocations and a resulting that (excluding a few conspicuous assumptions) is presumption that securitizations are, on balance, a detractor generally an overall lower-risk ESG exposure. Using from an ESG risk viewpoint. Empirically, however, the the developed framework affords a fixed income manager opposite is shown to be true. Analysis of the highest severity the opportunity to broaden their existing ESG integration ESG incidents at U.S. corporations since 2010 reveals that approach beyond their current corporate holdings. Such a the median associated price drawdown for equity of those framework and its resulting ESG risk mapping at an issuer companies was -16%, for their corporate bonds -3%, and and tranche level should be an important tool in managing for their securitized notes, 0%. any ESG-responsible fixed income strategy. The ESG evaluation framework described in this study sheds light on this empirical evidence because it is customized to the unique features of securitizations. Instead of excluding or
7 Property assessed clean energy financing
13 Appendix 1 Return analysis methodology
1) Using Sustainalytics historical ESG incident reporting, 4) Surrounding the date of the incident, we record the price we identify companies that have experienced the most return performance of representative equity, corporate, and severe ESG incidents (Impact rating of 5 or higher) from securitized issues, focusing on the period of days or weeks 2010 to present. surrounding the event. Where multiple securities of a type 2) We identify the subset of these companies with listed are available, we use those with the highest trading equity, corporate bond and securitizations outstanding volume and size. at the time of the incident. 5) We compare event-related performance across the equity, 3) We further limit the sample to investments where corporate bonds and securitized notes related to the Bloomberg or equivalent daily price information is available company experiencing the severe ESG event. for all of the relevant securities.
Appendix 2 Return analysis data samples
Cumulative Price Return Accompanying ESG Incident: Credit Suisse
1
0
-1
-2 1 22 201 : E launches - investigation into Swiss Franc rate fixing
-
- 1 1 1 1 1 1 0 0 0 01 01 0 0 0 2 2 2 2 2 2 2 2 8 9 0 1 2 1 1 1 2 2 2 2 2 1 1 1 1 1 1 1 1
CS Equity CS Subord Corp BBB CS Perp Corp BB CS Senior Corp A CSFB CMBS BBB
Sources: Bloomberg and BBH Analysis
Cumulative Price Return Accompanying ESG Incident: Nationstar
0
-2
-
- 2 201 : New ork regulator expresses -8 servicing concerns, halts Ocwen Wells deal -10
-12
-1
-1
NSM Equity NSM Corp B NMART ABS AAA NMART ABS AA NMART ABS A NMART ABS BBB NMART ABS BB
Sources: Bloomberg and BBH Analysis 14 14 Cumulative Price Return Accompanying ESG Incident: Sallie Mae
0
- 1 21 201 : Senator Warren introduces legislation to allow refinance of Sallie Mae FFELP -10
-1
-20
SLM Equity SLM Corp BB SLMA ABS AAA SLMA ABS AA
Sources: Bloomberg and BBH Analysis
Cumulative Price Return Accompanying ESG Incident: Wells Fargo
2
0
-2
- 9 8 201 : WFC agreed to pay S 190 million to settle accusations it pushed customers into - fee-generating accounts they never requested
-8
-10
WFC Equity WFC Senior Corp A WFC Subordinate BBB WFC CMBS AAA WFC CMBS Junior AAA
Sources: Bloomberg and BBH Analysis
Cumulative Price Return Accompanying ESG Incident: Ford Motor
0
1 201 : Ford expanded its North American Takata - air bag inflator recall by 1.0 million units
-10
-1
-20
F Equity F Corp BBB F ABS AAA F ABS AA F ABS A
Sources: Bloomberg and BBH Analysis
15 15 Cumulative Price Return Accompanying ESG Incident: Hertz Rental
0
-
-10
-1 19 201 : A class-action lawsuit filed -20 against Hertz by shareholders, accusing -2 the company of issuing false and misleading statements to investors with - 0 regard to the company s performance -
- 0 4 4 4 4 4 4 4 1 1 1 1 1 1 1 0 0 0 0 0 0 0 2 2 2 2 /2 2 /2 / / / / 5 / 5 /5 5 5 5 / /5 / 6 / / / 0 1 2 7 8 9 1 1 1 HT Equity HT Corp B HT ABS AAA HT ABS BBB
Sources: Bloomberg and BBH Analysis
Cumulative Price Return Accompanying ESG Incident: JP Morgan 5%
0%
- 9 2012: JPM discloses trading loss of ultimately .2 billion, blaming errors, sloppiness and bad udgement, which -10 stemmed from a hedging strategy that backfired
-1
-20
-2
2012 9 2012 11 2012 1 2012 1 2012 1 2012 19 2012 21 2012 2 2012 JPM Equity JPM Senior Corp A JPM CMBS AAA JPM CMBS Junior AAA
Sources: Bloomberg and BBH Analysis
Cumulative Price Return Accompanying ESG Incident: American Express
2
0
1 12 201 : Pending Department of Justice case that Amex -2 violated Sherman Antitrust Act by not allowing merchants to promote other cards udgement ultimately against Amex -
-
-8
-10
A P Equity A P Corp BB A P ABS AAA A P ABS A
Sources: Bloomberg and BBH Analysis
16 16 Additional BBH contacts
Niamh Bonus Senior Vice President BBH Investment Management [email protected] +1.212.493.8233
John Ackler Senior Vice President BBH Investment Management [email protected] +1.212.493.8247
Past performance does not guarantee future results.
Risks
The value of some bonds including asset-backed and mortgage-backed securities may be sensitive to changes in prevailing interest rates that can cause a decline in their prices. Although mortgage-backed securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.
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